If a taxing entity changes its tax law to retroactively include a transaction, should the hapless taxpayer be bound by the new rule?

Melvin Milligan, after winning $46 million in the New Jersey Big Game Lottery in June, 2000, elected to receive his winnings in annual installments as a multi-year annuity payment, at a time when the New Jersey Lottery advertised that those who won a prize were not required to pay state income tax on their winnings. State law also provided that such prizes were not included in gross income subject to New Jersey tax.

In 2009, an amendment was enacted to provide that New Jersey Lottery winnings exceeding $10,000 “shall be included in gross income” subject to tax and would apply to taxable years on or after Jan. 1, 2009.

Milligan and his wife filed an amended return for 2009 in which they excluded their lottery winnings from gross income, stating that they disputed the retroactive application of the amendment and seeking a refund of the gross income tax they paid on the winnings they received in 2009. The Division of Taxation upheld the denial of the Milligans’ refund claim.

In a lawsuit naming both the Division of Taxation and the Division of State Lottery as defendants, the Milligans alleged that the retroactive application of the amendment violates the due process and equal protection clauses of both the United States and New Jersey Constitutions; that the retroactive application of the amendment violated the common-law “manifest injustice” doctrine; and that the amendment constituted a breach of contract.

The New Jersey Tax Court denied last month a motion by the State Lottery to dismiss the complaint against it. The State Lottery argued that any claims Milligan had regarding the taxation of his lottery winnings must be asserted against the Division of Taxation rather than against the lottery. 

“If, and only if, plaintiffs do not prevail in their challenge to the Taxation Director’s denial of their refund claim will they proceed with their contract claim against the Division of State Lottery,” the court stated. “There is, therefore, no danger of plaintiffs securing more in damages than the amount of overpaid gross income tax they allege to be due to them…”

If the motion had succeeded, the Division of Taxation would have brought a similar motion, according to Steven Klein, a member at Cole Schotz P.C., who represented the Milligans. “The Lottery brought the motion, and the Tax Department was watching to see the result,” he said. “Based on what the judge said, there would be no basis now for the Division of Taxation to go ahead with a motion.”

Klein, who represents 11 other lottery winners, most of them with similar factual situations, said that they elected the annuity well before the new law went into effect. “To apply a new law imposing a tax to a situation from years before is either unconstitutional, manifestly unjust, or a breach of a contract that existed between the lottery player and the state,” he said. “We think that all of these are winning theories of liability.”

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